This document discusses absorption costing and marginal costing methods. Absorption costing recognizes fixed costs as part of the unit cost of production, allocating overhead costs based on various bases like direct labor hours. Marginal costing only includes variable costs in the cost of goods sold and treats fixed costs as a period expense. The document provides examples of calculating predetermined overhead rates and analyzing overhead under/over-absorption. It also justifies absorption costing as including an appropriate share of total overhead costs in the product cost.

1. ABSORPTION
COSTING
COMPILED BY F. CHANDILANGA

2. RECAP
CALCULATING THE COST OF A PRODUCT OR SERVICE
Full cost of sales
The cost of a product or a service can be built on a cost card. A commonly
found build-up of costs is therefore as follows.
$
Production costs
Direct materials A
Direct wages B
Direct expenses C .
Prime cost A+B+C
Production overheads D .
Full factory cost A+B+C+D
Administration costs E
Selling and distribution costs F .
Full cost of sales A+B+C+D+E+F

3. • A total of all direct costs is called prime costs
• A total of all indirect costs are called overheads
• Overheads are made up of indirect materials, indirect
labour and indirect expenses

4. MARGINAL COSTING
• In marginal costing, only variable costs are charged as a cost of
sale and a contribution is calculated (sales revenue minus variable
cost of sales). Closing inventories of work in progress or finished
goods are valued at marginal (variable) production cost. Fixed
costs are treated as a period cost, and are charged in full to the
profit and loss account of the accounting period in which they are
incurred. Contribution
Contribution is an important measure in marginal costing, and it is
calculated as the difference between sales value and marginal or
variable cost of sales.

5. Absorption costing recognises fixed costs (usually fixed
production costs) as part of the cost of a unit of output and
hence as product costs.

6. Absorption costing
The objective of absorption costing is to include in the total
cost of a product an appropriate share of the
organisation's total overhead. An appropriate share is
generally taken to mean an amount which reflects
the amount of time and effort that has gone into producing a
unit or completing a job.

7. Absorption costing stages
The three stages of absorption costing are:
• Allocation
• Apportionment
• Absorption

8. Overhead Allocation
The first step in absorption costing is allocation. Allocation is the
process by which whole cost items are charged direct to a cost
unit or cost centre e.g. a production department, to which
production overheads are charged
The following are examples of costs which would be charged
direct to cost centres via the process of allocation.
(a)The cost of a warehouse security guard will be charged to the
warehouse cost centre.
(b)Paper on which computer output is recorded will be charged
to the computer department.

9. Consider the following costs of a company.
Wages of the foreman of department A K200
Wages of the foreman of department B K150
Indirect materials consumed in department A K 50
Rent of the premises shared by departments A and B K300
The cost accounting system might include three overhead cost centres.
Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, i.e.
K200 + K50 to cost centre 101, K150 to cost centre 102 and K300 to
cost centre 201.

10. Overhead apportionment
The second step in absorption costing is overhead
apportionment. Apportionment is a procedure whereby
indirect costs are spread fairly between cost centres. Service
cost centre costs may later be apportioned to production cost
centres.

11. Bases of apportionment
Overhead costs should be shared out on a fair basis. The bases
of apportionment for the most usual cases are given below.
Overhead to which the basis applies Basis
Rent, rates, heating and light, repairs and
depreciation of buildings
Floor area occupied by each cost centre
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and
cost offices, first aid
Number of employees, or labour hours worked
in each cost centre

12. Example on overhead apportionment:
Maneno industry has incurred the following overhead costs.
K'000
Depreciation of factory 100
Factory repairs and maintenance 60
Factory office costs (treat as production overhead) 150
Depreciation of equipment 80
Insurance of equipment 20
Heating 39
Lighting 10
Canteen 90
TOTAL 549

13. Information relating to the production and service departments in the
factory is as follows.
Department
Production Production Service Service Totals
1 2 100 101
Floor space (square metres) 1,200 1,600 800 400 4,000
Volume (cubic metres) 3,000 6,000 2,400 1,600 13,000
Number of employees 30 30 15 15 90
Book value of equipment $30,000 $20,000 $10,000 $20,000 $80,000

14. Solution
Costs are apportioned using the following general formula.
Total overhead cost × value of apportionment base of cost
centre
Total value of apportionment base
For example, heating for department 1 =
3,000 ×K39,000
13,000
= K9,000

15. BASIS OF TOTAL DEPT 1 DEPT 2 SERVICE 1 SERVICE 2
APPORTIONMENT
Factory depreciation Floor space 100 30 40 20 10
Factory repair Floor space 60 18 24 12 6
Factory office cost Number of employee 150 50 50 25 25
Depreciation of equipment Book value of equipment 8 30 20 10 20
Insurance of equipment Book value of equipment 20 7.5 5 2.5 5
Heating Volume 39 9 18 7.2 4.8
Lighting Floor space 10 3 4 2 1
Canteen Number of employee 90 30 30 15 15
TOTAL 549 177.5 191 93.7 86.8

16. RE-APPORTIONMENT OF SERVICE COST CENTRE COST
The second stage of overhead apportionment concerns the
treatment of service cost centres. A factory is divided into several
production departments and also a number of service departments,
but only the production departments are directly involved in the
manufacture of the units. In order to be able to add production
overheads to unit costs, it is necessary to have all the overheads
charged to (or located in) the production departments. The next
stage in absorption costing is, therefore, to apportion the costs of
service cost centres to the production cost centres.

17. Service cost centre Possible basis of apportionment
Stores Number of materials requisitions
Maintenance Hours of maintenance work done for each cost centre
Production planning Direct labour hours worked in each production cost
centre

18. There are two main methods of reapportioning the
service department overheads to production
departments.
Direct method (ignores inter-service department
work)
Repeated distribution method (recognises inter-
service department work)

20. DepartmentA DepartmentB Stores Maintanance
OverheadCost 10030 8970 10000 8000
Reapportionmentofstores 3750 6250 -10000 _
Reapportionmentofmaintenance 7111 899 _ -8000
20891 16101 _ _
1. DIRECT METHOD

23. s Production
dept A
Producti
dept B
Stores Maintenance
$ $ $ $
Overhead costs 10,030 8,970 10,000 8,000
First stores apportionment
(see note (a)) 3,000 5,000 (10,000) 2,000
0 10,000
First maintenance apportionment 8,000 1,000 1,000 (10,000)
1,000 0
Second stores apportionment 300 500 (1,000) 200
Second maintenance
apportionment
160 20 20 (200)
Third stores apportionment 6 10 (20) 4
Third maintenance
apportionment
- 4 – (4)
21,500 15,500 0 0

24. Absorption of Overhead: Calculation of overhead absorption
rate
This is the final stage in absorption costing. An absorption
rate with which to absorb overheads has to be calculated.
Overhead absorption rate is a means of attributing overheads
to a product or a service based on for example direct labour
hours, direct labour cost, or machine hours

25. Example
Department 1 is largely machine based department while the
Department 2 is largely labour based.
Management has decided that Department 1 overheads should
be absorbed on the basis of machine hours and Department 2
should be absorbed on the basis of labour hours.
Using the first example on direct distribution method, and
having 10,000 as machine hours for Department 1, and 5,000 as
labour hours , calculate the absorption rates.

26. Solution
Department 1 cost per machine hour = K20891÷10000
=2.0891
=K2.09 per machine hour
Department 2 cost per labour hour = k16101÷5,000
=3.2202
= K3.22 per labour hour

27. Calculating predetermined overhead absorption rates
The absorption rate is calculated by dividing the budgeted overhead by
the budgeted level of activity. For production overheads the level of
activity is often budgeted direct labour hours or budgeted machine
hours.
Overhead absorption rates are therefore predetermined as follows.
(a)The overhead likely to be incurred during the coming period is
estimated.
(b)The total hours, units, or direct costs on which the overhead
absorption rates are to be based (activity level) are estimated.
(c) The estimated overhead is divided by the budgeted activity level to
arrive at an absorption rate for the forthcoming period, as follows

28. Total overheads of the cost centre
Total overhead absorption Rate =
Budgeted Activity Level
The base (denominator) is selected on the basis of type of the cost centre
and its contribution to the products or services, for example, machine hours,
labour hours, quantity produced etc based on normal capacity.
A pre-determined rate is used on a provisional basis for internal
management decision making such as cost estimates for quotation, fixation
of selling price etc. Budgeted overheads for the respective cost centres for
the period concerned are to be taken as numerator and budgeted normal
base for the period as denominator for determining the rate.
Overhead absorbed = Overhead absorption rate x units of base in product
or service

29. OVER AND UNDER ABSORPTION OF OVERHEADS
The amount of total overheads absorbed by a product, service or
activity will be the sum total of the overheads absorbed from individual
cost centres on pre-determined basis.
The difference between overheads absorbed on pre-determined basis
and the actual overheads incurred is the under- or over-absorption of
overheads.
 Over absorption means that the overheads charged to the cost of
production are greater than the overheads actually incurred.
 Under absorption means that insufficient overheads have been
included in the cost of production.

30. $
You can always work out whether overheads are under- or over-absorbed
by using the following rule.
•If Actual overhead incurred – Absorbed overhead = NEGATIVE (N), then
overheads are over-absorbed (NO)
•If Actual overhead incurred – Absorbed overhead = POSITIVE (P), then
overheads are under-absorbed (PU)
So, remember the NOPU rule when you go into your assessment and you
won't have any trouble in deciding whether overheads are under- or over-
absorbed!

31. Treatment for Over- Absorption
Over-absorption occurs when the actual overheads incurred are less
than the overheads absorbed. The effect is that the cost of sales will be
overstated whereas the gross profit will be understated because more
overheads have been charged to cost of sales than the actual
overheads that have been incurred. Since overheads are charged
before the actual cost is known, it is as if the customer was
overcharged. Because it may not be possible to refund a customer for
overcharging, the difference is credited to the income statement or
added to gross profit thereby improving operating results.

32. Treatment for Under- Absorption
Under-absorption occurs when the actual overheads incurred are
more than the overheads that have been charged to cost of sales
using predetermined absorption rates. It results into under-recovery of
overheads when charging to cost units. The effect is to understate the
cost of sales thereby overstating the gross profit because lower figure
of overheads has been included in cost of sales. Since the cost of
sales cannot be adjusted, the difference is subtracted from the gross
profit or debited to the income statement.

33. Causes of over or under absorption:
• Budgeted overheads differ from actual overheads
• Actual activity level is different from budgeted
• Both actual overheads and activity level differ from
budget

34. A company is preparing its production overhead budgets and determining the
apportionment of these overheads to products. Cost centre expenses and related
information have been budgeted as follows:
Total Machine Machine Assembly Canteen Mainten-
Shop A Shop B ance
Indirect labour 78,560 8,586 9,190 15.674 29,650 15,460
Consumable materials 16,900 6,400 8,700 1,200 600 -
Rent and rates 16,700
Building insurance 2,400
Power 8,600
Heat and light 3,400
Depre of machinery 40,200
Additional information
Area (m2) 45,000 10,000 12,000 15,000 6,000 2,000
Value of machinery 402,000 201,000 179,000 22,000 - -
Power usage- technical estimates 55% 40% 3% - 2%
Direct labour hours 35,000 8,000 6,200 20,800 - -
Machine usage (hrs) 25,200 7,200 18,000 - - -

35. Required:
(a) Determine the budgeted overhead absorption rates for each of the
production departments, using bases of apportionment and absorption
which you consider most appropriate from the information provided.
(b) On assumption that actual activity was:
Machine shop A Machine Shop B Assembly
Direct labour hours 8,200 6,500 21,900
Machine usage hours 7,300 18,700 -
And the total production overhead expenditure was MK 176,533 calculate
the over- or under absorption.

36. Basis of
apportionmen
t
Total Machine
shop A
Machine
shop B
Assembly Canteen Maintananc
e
Indirect labour Allocated 78560 8586 9190 15674 29650 15460
Consumable
materials
Allocated 16900 6400 8700 1200 600 -
Rent and rates Floor area 16700 3711 4453 5567 2227 742
Building
insurance
Floor area 2400 533 640 800 320 107
power Usage 8600 4730 3440 258 172
Heat and light Floor area 3400 756 907 1133 453 151
Deprec of
machinery
Machine
value
40200 20100 17900 2200 - -
Totals 166,760 44816 45230 26832 33250 16632
Reapportionme
nt
Canteen Direct labour
hrs
0 7600 5890 19760 (33,250)

37. Absorption basis Labour hrs Machine hrs Labour hrs
Volume 57168/8000 63000/18000 46592/20800
OAR 7.15 3.50 2.24
Over/Under absorption
K
Actual overheads incurred 176,533.00
Overheads absorbed:
Machine shop A 8,200 hrs x K7.15 58,630
Machine shop B 18700 hrs x 3.50 65,450
Assembly 21,900hrs x K2.24 49,056 173,136.00
(Over/Under-absorption 3,397
This shows that there was an underabsorption of K3,397

38. Justification and criticisms for
absorption costing

39. Marginal costing
(i) Concept of contribution
(ii) Product costing and pricing
(iii) Justification and criticisms for marginal costing

40. Marginal costing
Marginal costing is an alternative method of costing to
absorption costing. In absorption costing or full cost, the
production cost takes both variable and fixed cost into
account and one is able to calculate the total cost per
unit.
In marginal costing, only variable costs are charged as a
cost of sale and a contribution is calculated (sales
revenue minus variable cost of sales). Fixed costs are
treated as a period cost, and are charged in full to the
profit and loss account of the accounting period in which
they are incurred

41. The marginal production cost per unit of an item usually consists
of the following.
• Direct materials
• Direct labour
• Variable production overheads
The marginal cost of sales usually consists of the marginal cost
of production adjusted for inventory movements plus the variable
selling costs, which would include items such as sales
commission, and possibly some variable distribution costs.

42. PRODUCT COST
MARGINAL COSTING ABSORPTION COSTING
Direct material Direct materials
Direct labour Direct labour
Variable overhead Variable overhead
Fixed overhead
The following is a summary of Absorption costing and Marginal costing

43. PREPARING INCOME STATEMENT ACCORDING TO BOTH
MARGINAL AND ABSORPTION COSTING
The treatment of the marginal costing and absorption costing in the income
statement will be as follows (assuming that there is no opening and closing
inventories):
MARGINAL COST
SALES XX
LESS: VARIABLE COST
Direct material XX
Direct labour XX
Variable production overheads XX
Other variable costs:
Administrative expenses XX
Selling expenses XX ( XX)
= CONTRIBUTION XX
LESS FIXED COST (XX)
NET PROFIT XX
ABSORPTION COSTING
SALES XX
LESS: PRODUCTION COST
Direct material XX
Direct labour XX
Variable production overheads XX
Fixed production overheads XX (XX)
=GROSS PROFIT XX
LESS OTHER COSTS
Selling cost (fixed and variable) XX
Admini cost (fixed and variable) XX (XX)
NET PROFIT XX

44. Example
The following information relates to a single product, Phwafulira, made by NAF Ltd during May 2020
Opening inventory 0
Number of units produced 9000
Number of units sold (at K540 per unit) 7200
Direct materials cost per unit K90
Direct labour cost per unit K180
Variable production overhead per unit K90
Variable selling cost per unit K20
Fixed production overhead cost K450000
Fixed selling and administration cost K180000
You are required to draft the income statement for May 2020 using:
i) Marginal costing method
ii) Absorption costing method

45. MARGINAL COSTING METHOD INCOME STATEMENT
Sales (7200* 540) 3 888 000
Less variable cost
Opening inventory 0
Variable manufacturing costs (K90+K180+K90)=K360 × 9000 3 240 000
Goods available for sale 3 240 000
Closing inventory (1800 × K360) (648 000)
Variable cost of goods sold 2 592 000
Variable selling expenses (7200 × K20) 144 000
Total variable cost (2 736 000)
Marginal income/Contribution 1 152 000
Less fixed cost: manufacturing cost 450 000
selling and administration cost 180 000 (630 000)
Net profit 522 000

46. ABSORPTION COSTING METHOD INCOME STATEMENT
Sales (7200* 540) 3 888 000
Less manufacturing costs
Opening inventory 0
Fixed manufacturing cost 450 000
Variable manufacturing costs (K90+K180+K90)=K360 * 9000 3 240 000
Goods available for sale 3 690 000
Closing inventory (1800 × K410) (738 000)
Total manufacturing costs (2 952 000)
Gross profit 936 000
Other costs: fixed selling and administrative cost 180 000
variable selling cost 144 000 (324 000)
Net profit 612 000

47. Note that there is a difference in the net profit according to the method used. This is due
to the fact that there was closing inventory on hand. When using absorption costing, the
value of inventory contains both fixed costs and variable costs while when using marginal
cost the closing stock has only variable cost.
Remember that both fixed and variable costs are included in the cost of a product under
absorption costing. This means the closing inventories will as well have both fixed and
variable costs.
Under marginal costing, only variable costs are considered as the cost of a product,
therefore closing inventories will be valued at variable cost only
COST PRICE OF INVENTORY ON HAND
MARGINAL COSTING ABSORPTION COSTING
Direct material Direct materials
Direct labour Direct labour
Variable overhead Variable overhead
Fixed overhead

48. RECONCILING THE MARGINAL PROFIT FIGURES
AND THE ABSORPTION PROFIT FIGURES
The reported profit figures using marginal or absorption costing will differ
if there is a change in the level of inventory during the period.
If production is equal to sales i.e. there is no closing inventory, then there
will be no difference.
If inventory levels increase between beginning and end of the period,
absorption costing will report a higher profit (because fixed costs are
carried forward and not included in the cost of sales)
If inventory levels decrease, absorption costing will report a lower profit
because some fixed costs are not carried forward and included in the cost of
sales. Instead they are included in the opening inventory of the next period.

49. Example
Using the previous example, profit under absorption and marginal costing can be reconciled as
follows:
Marginal costing profit K522 000
Adjust for fixed production overhead inventory
(inventory increase of 1800 * K50 per unit K 90 000
K612 000
This gives us the absorption costing profit